Trade like warren buffett

Contents CHAPTER 5 Merger Arbitrage Like Warren Buffett 79 CHAPTER 9 Warren Buffett’s Personal Holdings 149 CHAPTER 11 Interviews with Two Buffett-Style CHAPTER 12 P/E Ratios, Market Ti

Trade Like Warren Buffett

JAMES ALTUCHER

John Wiley & Sons, Inc

Trade Like Warren Buffett

John Wiley & Sons

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Trade Like Warren Buffett

JAMES ALTUCHER

John Wiley & Sons, Inc

Copyright © 2005 by James Altucher All rights reserved

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Library of Congress Cataloging-in-Publication Data

Altucher, James.

Trade like Warren Buffett / James Altucher.

p cm — (Wiley trading series) ISBN 0-471-65584-8 (cloth)

1 Investments 2 Buffett, Warren I Title II Series.

HG4521.A4559 2005

332.6—dc22

2004020828 Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

To Sam Vitiello and Seymour Altucher,

two great fathers.

Contents

CHAPTER 5 Merger Arbitrage Like Warren Buffett 79

CHAPTER 9 Warren Buffett’s Personal Holdings 149

CHAPTER 11 Interviews with Two Buffett-Style

CHAPTER 12 P/E Ratios, Market Timing,

and varied career as to create the material that was then used forthis book I hope I learned something

Dave Morrow and Jim Cramer at TheStreet.com, and Steve Schurr and Lionel Barber at the Financial Times, have nurtured the environments that have allowed me to write and interact with other investors and writers Real-

Money.com and the Financial Times have been great homes for my articles

and I’m grateful George Moriarty, Gretchen Lembach, Aaron Task, and AdamBatchelder have had the grueling task of editing and reediting my articles at

TheStreet.comand they have helped me have a lot of fun in the process.Michelle Donley, Karen Ludke, and Omid Malekan all have helped me

in various stages of editing this book and all three have had no shame whentelling me which chapters and passages could be a lot better Thanks forcreating a whole lot more work for me and I hope I can return the favorsome day!

As usual, Dan Kelly has been both sounding board and psychiatristthroughout the writing and production of this book Particular thanks forfollowing up on that bounced email to Debbie, enabling us, for once, to befooled by randomness

Special thanks to Tim Melvin for pointing out to me Buffett’s personalholdings

Michael Angelides, Neal Berger, Jay Kaplowitz, Worth Gibson, StephenDubner, Joel Gantcher, Cody Willard, and Jim Moore and too many others

to mention have all played key roles in encouraging and developing myother activities while I have been writing this book Pamela van Giessen ofWiley has continued to be a great support and confidante throughout thisentire process and I am greatly appreciative And finally, Anne, Josie, andMollie deserve special thanks for having put up with yet another summer ofwriting a book I hope to make it up to them ten-fold

Acknowledgments

C H A P T E R 1

Does Warren Buffett Trade?

My favorite holding period is forever.

—Warren Buffett

First, I have to apologize in advance This book barely mentions

Coca-Cola or the Washington Post I also don’t really talk about the

many fine companies that Berkshire Hathaway has bought overthe past three decades (See’s Candies, the Pampered Chef, Dairy Queen,National Furniture Mart, and others) There are many excellent books thatcover these topics And while Warren Buffett has made billions of dollarsfrom these investments, I don’t think I can add to the already great dialoguethat has taken place on these topics

Nor is this book really about value investing There are many tions of value investing and many treatises on value versus growth Buteven Buffett has stated that on the whole, the distinctions between valueand growth are nonsense This book is about the various ways that Buffetthas applied the concept of “margin of safety” outside of his buy-and-holdstrategies He has had a longer and more diverse investment career thanjust about anybody There are several people in the world (fewer than ten,actually) who have had more years’ experience than Buffett at pickingstocks, but I can think of no one who has traded and invested with a more

defini-diverse group of strategies over the past fifty years It is these strategiesthat I write about Many of them are normally thought of as “trading” strate-gies instead of the buy-and-hold investing for which Buffett is famous When I went to the Berkshire Hathaway annual meeting in 2003 I had

no idea what I would encounter I met one man who bought 200 shares ofBerkshire Hathaway in 1976 for $15,000, give or take He sold half of thoseshares a year later for a solid double (who can blame him?) and today theremaining shares are worth over $9,000,000 He now hangs out skiing inTahoe for most of the year

I asked him why he had bought those shares and he said that he hadheard of Warren Buffett while growing up in the same town as him, had heard

he was smart, and liked the insurance industry One can argue that this man

I had spoken to was an incredible investor He had turned $15,000 into

$9,000,000 over the course of 25 years—a 50,000 percent return!

Not everyone at the meeting was as lucky Most of the people at themeeting were fairly recent owners of their shares and were either mildly up

on their investment or flat At the time of this writing Berkshire Hathaway

is close to making an all-time high, so hopefully most of these people haveheld onto their shares Throughout the meeting I asked people why theywere there After all, it was the most popular annual meeting in the com-pany’s history, with approximately 15,000 people in attendance Some peo-ple were there because they just wanted to see Warren Buffett Whatzeitgeist had he been tuned into all his life that he could start with $100 andcompound it into $40 billion? While at the same time maintaining his home-spun humility and simple lifestyle (he still lives in the same house he bought

40 years ago for $30,000)

Buffett supposedly found these incredible deals through the principles

of value investing Again, there are many good books out there about value

1The most famous of the books is Robert G Hagstrom’s The Warren Buffett Way:

Investment Strategies of the World’s Greatest Investor Others include How to Pick

Stocks Like Warren Buffett: Profiting from the Bargain Hunting Strategies of the World’s Greatest Value Investor by Timothy Vick and How to Think Like Ben

Graham and Invest Like Warren Buffettby Lawrence Cunningham All of these are good books that focus on investing in companies with solid management, good cor- porate governance, high return on equity, a good brand, and so on.

book I try to provide a comprehensive suggested reading list of the majorbooks written about Buffett

However, Buffett achieved much of his early success from arbitragetechniques, short-term trading, liquidations, and so on rather than using thetechniques that he became famous for with stocks like Coca-Cola or CapitalCities In the latter stages of his career he was able to successfully diversifyhis portfolio using fixed income arbitrage, currencies, commodities, andother techniques And further, in his personal portfolio he tended to stick tothe style of deep value investing that marked his early hedge fund years

This book is titled Trade Like Warren Buffett, and the phrase alone

brings up several contradictions in the traditional mythos about Buffett First, Warren Buffett supposedly does not trade He finds an undervaluedgem, then buys and holds onto it forever After all, it takes a million years

to turn a piece of coal into a diamond, and a good company should alwaysbare that in mind For example, Buffett bought Gillette in the 1980s and, to hiscredit, many multiples later, he still holds onto it After all, people willalways shave, so the demographic for Gillette is approximately 3,000,000,000citizens of this planet How can you go wrong holding this stock forever? Exhibit 1.1 represents the holding period of some of the BerkshireHathaway trades that Buffett held for less than five years

Second, the world of trading usually evokes images of day traders, gers on the trigger, ready to scalp stocks for a few ticks several dozen times

fin-a dfin-ay Seldom do people think of Wfin-arren Buffett, known for holding ontostocks for years, when the subject of day trading comes up

However, the texture of value investing now is very different than whenWarren Buffett was making his early profits, let alone when Benjamin

Graham and David Dodd wrote their classic text Security Analysis Back

then, there was only a limited set of eyes that had the access to information,not to mention the desire, to locate companies that fit a certain deep valuecriterion But today if I want to sift through six thousand stocks to findsome that fit specific earnings, ROE (Return on Equity), P/E (price overearnings ratio), and other criteria, then I can easily do so with any number

of stock screeners online And, believe me, countless value investors aredoing just that The information arbitrage that existed in the 1960s and ear-lier is nearly nonexistent today

Buffett would spend hours going through Moody’s reports on each stock,

sifting for the gold among the dirt And, after spending hundreds of hours

doing that (an activity that might now take one hour, tops), he would have tothen figure out how to actually buy the shares he wanted For instance, whenBuffett was trying to buy shares of Dempster Mining he had to drive to thetown where they were based and convince locals to sell their shares to him.There was no liquid market out there like there is now So when he bought

the shares, he had to hold them for longer then he might have wanted to

So, value investing the way Buffett and Graham practiced it no longerexists today There are thousands of mutual funds and hedge funds com-

Year of Time Held

peting for those arbitrage opportunities, not to mention retail investorswith access to the Internet

During Buffett’s hedge fund years (between 1957 and 1969) there weresome years in which more than half his profits came from what he called

“workouts”—special situations, merger arbitrage opportunities, spin-offs,distressed debt opportunities, and so on Playing with semantics, we canargue that all of those opportunities represented “value”—that is, buyingsomething that is cheaper than what it was worth—whether it was aspread between two securities, a distressed bond, or a stub stock thateveryone ignored However, these situations are not usually described asvalue investing

Instead, over the past two decades we have seen Buffett dip his ing prowess into commodities (his foray into silver in 1997), fixed income

invest-arbitrage, many instances of distressed debt through the use of private

investment in public equity(PIPE) vehicles, merger arbitrage, relativevalue arbitrage, and so on In addition, Buffett has made his first foraysinto technology investing, owning over the past few years a number ofshares in telecommunications services company Level Three and the debt

of e-commerce company Amazon; the latter is a company that had neverproduced a dime of earnings when Buffett first invested in it, let alone aneasy means by which someone could compute future cash flows

There are three stages to Buffett’s investment career, and we will focus

on techniques used inside each of those phases

Buffett’s hedge fund years were when he built his fortune from tially nothing to about $25 million at the time he was interviewed by Adam

essen-Smith for his 1971 classic, SuperMoney During this time Buffett had three

techniques:

its original form) fell This meant buying stocks that were selling forless than tangible assets Buffett would sometimes accumulate enoughshares that eventually a change of control would occur, giving himdirect power over how the assets of the company would be disposed

THE EARLY YEARS

2 Value investing, but combined with some of his partner CharlieMunger’s ideas on growth and the potential of brands This resulted inBuffett’s American Express play, among others

arbi-trage, spin-offs, and so on

The 1970s and 1980s were the decades when Buffett made the full tion from successful hedge fund manager to operator, asset allocator, andinsurance company magnate Why the insurance business? And why did heleave the hedge fund business? We know now in retrospect that he was avery good market timer, although prone to being early, just as BernardBaruch said, “I always sold too soon.” So it could be argued that Buffett’sdeparture from the hedge fund business right before an essentially flatdecade was a sign of good market timing However, I don’t believe this

transi-I believe that Buffett did anticipate a potentially horrendous decade forstock market returns, and in fact, 1973–74 was the worst downturn sincethe 1930s But I don’t think that Buffett would have stopped his hedge fundfor fear of poor market returns Rather, he was always more enthusiastic inhis annual letters to his partnership investors when the market was doingits poorest He prided himself more on outperformance than absolute performance A return of 20 percent in a year when the market was up

30 percent would have been a disaster for him Far better would be to

the fact that the market was about to make a strong downturn would nothave been the impetus to cause him to wind down his hedge fund and gointo the insurance business

Rather, I think he saw an opportunity unlike any he had encountered inthe past and he wanted to pounce on it The way Buffett’s partnership wasstructured, he took a 0 percent management fee and 25 percent of all prof-its As an example, if his fund had $5 million in it and he returned 20 per-cent, or $1 million, for his investors, then he would take 25 percent of that,

or $250,000 of that, as his fee

However, an insurance company is much more attractive to a masterasset allocator like Buffett An insurance company works like a hedge fund

THE MIDDLE YEARS

except Buffett gets to keep 100 percent of the profits People “invest” theirmoney when they pay their premiums and only get to take their money outagain upon illness or disaster In a well-run insurance business the “cost offloat” is ideally zero; that is, you spend no more in payouts than you take inpremium In this way, all profits go to the owners of the business If the cost

of float is zero, then the economics of the insurance business are much ter than the economics of a hedge fund

bet-Rather than retire to a lifetime of bridge playing, Buffett ended upbuying for $40/share most of the Berkshire Hathaway shares that he hadoriginally bought for his investors (profitably for them at prices rangingfrom $7 to $16 per share) Then, while Buffett used Berkshire as his base,the rest of the 1970s became a rollup of insurance companies, regionalbanks, and other cash-producing assets ranging from the Nebraska Fur-niture Mart to See’s Candies

It was during this period that he became less focused on his workoutplays and more focused on his “control” plays like the insurance compa-nies, furniture companies, and chocolate companies he was buying and his

“generals”—the big value plays like Coco-Cola and Gillette that ultimatelycreated billions of dollars in investment profits for Berkshire

There is no one way to sum up Buffett’s investment style during thisperiod Early on, he was certainly interested in buying companies for lessthan their book value The Washington Post is a great example, where hebegan accumulating shares at a fraction of their liquidation value Later on,however, particularly in the 1980s, his methods were much less quantitativeand bordered on highly subjective A case in point is Coca-Cola, which Buf-fett began accumulating in 1988; he ultimately became the largest share-holder Coke was trading at 13 times earnings, hardly a discount to themarket at that time, which was trading around 10 times forward earnings.That said, Buffett was convinced, and he was right, that Coke was trading

at a huge discount based on the future earnings of the company

“The Middle Years” are perhaps the least interesting period for me.However, this period (the 1970s and 1980s) is the subject of countless

and documents Buffett’s stock picks during this period

2The Warren Buffett Way, Robert Hagstrom (Wiley, 1993).

I repeat the following refrain throughout the book: It is not possible

to trade exactly like Warren Buffett The goal is to use whatever meanspossible to approximate his trading by attempting to quantify the term

“margin of safety”

The 1990s and then the 2000s created an interesting dilemma for Buffett,one that no other company has ever faced He simply had too much cash toput to work As much as he loved finding quality companies and stocks, theworld was just too small for him at this point In lectures that he occasion-ally gave to college students he would often sentimentally reflect that if hehad less money he could still return 50 percent a year in arbitrage situa-tions But with $50 billion to put to work this was just impossible Nor is iteasy to go through the market and find the slim pickings Let’s say a $1 bil-lion company is trading at a cheap price and Buffett is able to buy 10 per-cent of it Assume that it then goes up 100 percent for him over the nextyear—a truly remarkable return It would still only increase the book value

of Berkshire Hathaway by 0.2 percent

Instead, the 1990s saw several trends developing in Buffett’s style Firstthere was a flight to safety In the late nineties, when the world was hap-hazardly buying everything with dot-com written all over it (author disclo-sure: I was, too), Buffett was diversifying into bonds, into silver, fixedincome arbitrage, and ultimately foreign currencies

So given the fact that Buffett’s investment career has spanned fivedecades and multiple styles and disciplines, is it possible to “trade likeWarren Buffett”?

It is not possible to trade exactly like Warren Buffett The best we can do isapproximate his approach, plead in each trading situation for the margin ofsafety that Buffett always demands, and try to develop our own approachesthat are, if not exact replicas, at least Buffett-like But why can’t we tradelike him? To summarize the three main reasons:

IT’S TOO LATE

THE LATER YEARS

1. The Internet has changed everything.Every SEC filing, every newsreport, every inside transaction, and every earnings release is instantlyposted to the Internet and available to the tens of thousands of investorswho are looking for low price to book, high return on equity companies.Although many studies have come to the conclusion that too many retailinvestors are naive, the reality is that there are many good investors outthere who know how to make use of the information at their fingertips.

No longer does an investor have to dig through tattered old filings tofind the next Dempster Mining and then drive around Nebraska to findrandom shares in it

2. Arbitrage spreads have narrowed.The “workout” trades that Buffettmastered in his hedge fund days are no longer as easy to accomplish asthey once were When Buffett started out, only a handful of hedge fundsexisted that were attempting to use those techniques Now there areover 7,000 hedge funds trying to squeeze the blood out of every arbitragesituation While the opportunities still exist—opportunities that we willexamine in depth in later chapters—they are of a much different breedthen what Buffett first encountered

3. People don’t give us money Warren Buffett has enormous deal flow.Every day opportunities are placed in front of him, and often the types

of deals are not those that are available to the average investor Theflipside to this is that he also has a lot of bad deals put in front of him,and it takes acumen to sift through these questionable opportunities tofind the gems However, his gems might be 10-carat diamonds, whereasthe average investor needs to settle for a few inclusions and work his

or her way up from there

But don’t despair The key thing to focus on is Buffett’s constant desire for

a margin of safety With each style of investing that he delves into, he sistently requires a certain degree of safety; investors who attempt to applyhis techniques should do the same Also, the average investor has severaladvantages over Warren Buffett, both the Buffett from his early hedge fundyears and the Buffett of the 1990s and 2000s

IT’S NOT TOO LATE

1. The Internet.The same phenomenon that was listed as a disadvantageabove is also an advantage The reality is that it is easier to research anyinvestment possibility under the sun It is also easier to quantify andback-test various approaches to verify that an approach has at leastbeen statistically sound in the past Buffett has a great appreciation forthe quantifiable side of investing; it would be interesting to see what hecould have done had he had the capabilities of the Internet behind himwhen he started

2. Size is important.Buffett is simply too big He cannot enter into aposition easily without causing the entire world to react accordingly.For instance, when he started buying up silver he wasn’t simply mak-ing a small investment He ended up becoming the largest investor insilver since the Hunt Brothers, controlling not just a small amount, but

25 percent of the entire world’s above-ground supply And still thiswas just a tiny, miniscule drop in the bucket for the Berkshire Hath-away portfolio Getting into and then out of this market was no easytask for Buffett either Silver, which had been in a slump for years,jumped 30 percent when it was discovered that Buffett was making

an investment

No wonder Buffett likes to tell people to buy and hold If investorsfeel like selling something that Buffett owns, there is almost zerochance Buffett can get out before the other interested sellers do.Clearly, if everyone had a philosophy of “buy and hold forever,” itwould be much better for Buffett’s investments, since he can’t reallysell The reality is that during his career he has done much selling andhas held even some core value plays (McDonald’s and Disney are greatexamples) for short periods of time

The fact that the average investor is much more nimble is a hugeadvantage, although it is an advantage that cannot be treated lightly due

to the damage it can cause Many studies have been done that show thatthe average retail investor is damaged by too high a turnover in his or herportfolio Ultimately, though, it is better to have the option than to nothave it at all

The remainder of this book is mostly broken down by investment style

Merger Arbitrage

Buffett made significant use of merger arbitrage (buying the stock of a pany being acquired and selling short the acquirer) in his hedge fund daysfrom 1957 to 1969 As recently as the 1998 Berkshire Hathaway conference

com-he stated that if com-he only had a small amount to play with com-he could still earn

50 percent a year using merger arbitrage techniques

Relative Value Arbitrage

“Relative value” is a catch-all phrase that takes advantage of any ancy between the spread in values between two assets A great example(which Buffett did not play as far as I know) was when 3COM (Nasdaq:COMS) spun out Palm (Nasdaq: PALM) and the shares 3COM owned inPALM were worth significantly more than the entire market cap of 3COM.Buying 3COM and shorting PALM was a straightforward exploitation ofthat discrepancy and had a fair amount of margin of safety associated with

discrep-it Of course, the spread could get worse before it gets better For example,Eifuku, a hedge fund in Japan that was wiped out in less than two weeks in

2003 from applying these techniques), but hey, that’s what makes it somuch fun

Bonds

Buffett has spoken several times over the past 40 years about the merits

of the Federal Reserve model in market timing More recently, when theeconomy was slowing and the market was getting significantly overvaluedrelative to interest rates, Buffett made the impressive move of switching hisportfolio so he was heavily weighted in bonds Masterfully, he did this with-out incurring any tax penalty at all (that is, he didn’t have to allocate out ofstocks and into bonds)

We will look at the merits of various applications of the Fed model andsome studies that have been done in this area; included in this book areinterviews with several managers who focus on investing in bonds

THE INVESTMENT STYLES

Fixed Income Arbitrage

As much as Buffett has a distaste for derivatives and leverage, he does diphis toes into the world of fixed income arbitrage, the idea of buying andselling different interest rate derivatives with different time payoffs What

is fixed income arbitrage, how does Buffett invest in it, what are theadvantages and disadvantages? While this is normally considered a verysolid and safe way to invest, it should be pointed out here that Long-TermCapital Management, the highly pedigreed hedge fund that lost billion ofdollars in 1998, also felt this was a very safe way to invest the money oftheir investors

Stocks

I didn’t want this to be a book “like all the others,” and most other booksabout Warren Buffett focus on his stock-picking techniques However, thereality is that this topic cannot be ignored in any work about Buffett What

I hope to offer to the dialogue is an examination of studies done on thetechniques that Buffett supposedly uses for his stock picking

And finally, we will examine and study the principle of mean sion The commonly quoted aphorism is to “buy when there is blood in thestreets.” Buffett and Graham both recount the story of Mr Market, who isalways buying when things are too expensive, and selling when things are too cheap Mr Market is often crushed by the idea of mean reversion.Without focusing specifically on value investing, can the average investorquantify an approach to mean reversion that still carries with it the concept

rever-of margin rever-of safety?

Commodities

Buffett has never been a big fan of investing commodities However, he hasseveral times made the plunge, most recently with silver Many people whotrade commodities do so based on the technicals, chart reading, and puresystems trading It is interesting to see how Buffett applies his principles

of value investing to commodities

Currencies have never been a popular Buffett investment In fact, Buffettonly began buying currencies in the past year “Buy what you know” is theslogan of Buffett fans, and Buffett knows the United States better than heknows any other country We will explore what made him finally invest inforeign currencies later in this book

Finally, the book concludes with a suggested readings section thatcatalogs the primary books that discussed or influenced Buffett

C H A P T E R 2

Graham-Dodd and a Dose

of Fisher

Warren Buffett claims to be “15 percent [Philip] Fisher and 85

percent Benjamin Graham.” You could make the argument thatthe inverse is true, although I take Buffett at his word and think he is correct, particularly when you look at the activities of hishedge fund from 1957 to 1969 and the activities of his personal portfolio.(Not to mention his overriding philosophy of always looking for a margin

of safety.)

Let’s begin with a few notes about Fisher Philip Fisher, the author of

Common Stocks and Uncommon Profits, advocated buying a focused

port-folio, a few companies with above-average potential How is it possible todetermine above-average potential?

• Focus on growing sales

• Focus on expanding research and development (R&D) since that willkeep the company ahead of the curve and capable of growing sales inthe future

• Demographics need to be monitored Is the market for this companygoing to continue to grow?

• Management should be strong and communications with shareholdersshould be direct and honest

How does one get the low-down on management? This is what Fisherrefers to as “scuttlebutt.” Interview customers, management, employees,other investors, journalists, and so on Get the information any way you can.Fisher was also a big fan of focus investing This is the idea that peopleshould only buy a few stocks The idea makes intuitive sense in that you canonly focus on a few stocks at a time anyway If you were in 200 stocks itwould be much harder to follow all of the movements of each stock, and

it becomes much more likely that, in the best-case scenario, all you do istrack the overall market

There has been interesting research recently on several of Fisher’s teria For instance, looking at the R&D expenses of a company is notalways helpful The way a company expenses research and developmentmight be just an accounting trick However, there is a way to look at R&D

cri-in a way that is correlated with future stock market performance

According to CHI Research, a consulting firm that focuses on studyingthe intellectual property of companies, a company’s patent portfolio is apredictor of future stock performance The quality of the patent portfoliocan be assessed by, among other things, the statistics related to forwardcitations to the patents A forward citation is a note on the front of a laterpatent that states which prior patents the patent pending is improvingupon The more patents the patent is improving, the more well-spent theR&D dollars were in creating that patent

From 1989 to 1998, CHI constructed a test, selecting the 25 companiesmost undervalued based in part on patent quality indicators such as highlycited patents and short technology cycle times, that is, shorter than theaverage for their industries

As we can see in Exhibit 2.1, the patent/R&D–heavy companies steadilyoutperformed the S&P and even outperformed the Nasdaq by a wide mar-gin during 2000, when tech stocks were down by a wide margin

In fact, CHI Research itself has a patent for its method of picking astock portfolio based on the quality of the patent portfolio for each stock(see Exhibit 2.2)

The issue about diversification is a tug-of-war between Graham-Doddpurists and Fisher purists Fisher advocates a “focused portfolio” approach,that is, a portfolio with just a few stocks in it so that it is easier to follow,research, and manage them Graham-Dodd advocates more extensive diver-sification Fisher’s point—a valid one—is that the more stocks in your port-

folio, the harder it is to follow them As Buffett has stated, “Wide cation is only required when investors do not understand what they are

diversifi-doing.” And Robert Hagstrom, in his books The Warren Buffett Portfolio and The Essential Buffett, has done some excellent research on the value

of a focused portfolio

Academic research in this area received a boost from a paper by twoUniversity of Michigan professors, Clemens Sialm and Lu Zheng, and one of

looking at all mutual fund data from 1984 to 1999 was that actively trated portfolios perform better than funds with diversified portfolios Theyalso tend to outperform the market, despite the evidence that actively man-aged funds in general (including the ones with high diversification) tend tounderperform the market The outperformance occurred both in the 1980sand 1990s, and was sector-independent (so it was not just technology)

Source: Reprinted from the CHI Research website, http://www.chiresearch.com, 2004.

Sialm, Lu Zheng, and Marcin Kacperczyk, Journal of Finance, 2005.

The reason for this is clear: With a portfolio of just a few stocks, it ispossible that the active manager is able to obtain better information abouteach stock than if the manager had 200 stocks in his or her portfolio Thisinformation advantage results in better performance on the whole, which isprecisely Buffett’s (and Fisher’s) point.

EXHIBIT 2.2

Source: Reprinted from the CHI Research website, http://www.chiresearch.com, 2004.

CHOOSING A STOCK PORTFOLIO, BASED

ON PATENT INDICATORS

(75) Inventors: Anthony F Breitzman, Cedarbrook;

Francis Narin, Ventor, both of NJ (US) (73) Assignee: CHI Research, Inc., Haddon Heights,

NJ (US) (*) Notice: Under 35 U.S.C 154(b), the term of this

patent shall be extended for 0 days.

Stobbs Gregory: “Turning the Corporate Patent Portfolio

Using the Latest Software Tools” MapiT Briefing Report,

Manning & Napier, Jun 1997.*

McGuire, Craig: “The Next Level of Proprietary

Protect-tion”, Wall Street & Technology, Jan99, vol 17 Issue 1, p52,

1p.”

J.S Perko et al.: “The Transfer of Public Science to Patented

Technology: A Case Study in agriculture Science” Journal

of Technology Transfer, vol 22(3) 65–72, 1997.*

CHI Research, Inc Introduces Tech–Line Analysis Tool Technology, Information Today, V 15, n 9, p 66, Oct 1998.* Deng, Z., Lev, B., and Narin, F “Science and Technology as Predictors of Stock Performance” (Financial Analysts Jour- nal, vol 55, No 3, May/Jun 1999, pp 20–32) Rosenberg, N and Birdzell, Jr., L.E “Science, Technology and the Western Miracle” (Scientific American, vol 263,

No 5, Nov 1990, pp 42–54).

(List continued on next page.)

Primary Examiner—Tod R Swann Assistant Examiner—Jagdish N Patel

(74) Attorney, Agent, or Firm—Akin, Gump, Strauss,

Hauer & Feld, L.L.P.

A portfolio selector technique is described for selecting publicly traded companies to include in a stock market portfolio The technique is based on a technology score derived from the patent indicators of a set of technology companies with significant patent portfolios Typical patent indicators may include citation indicators that measure the impact of patented technology on later technology Tech- nology Cycle Time that measures the speed of innovation of companies, and science linkage that measures leading edge tendencies of companies Patent indicators measure the effect of quality technology on the company’s future per- formance The selector technique creates a scoring equation that weights each indicator such that the companies can be scored and ranked based on a combination of patent indica- tors The score is then used to select the top ranked companies for inclusion in a stock portfolio After a fixed period of time, as new patents are issued, the scores are recomputed such that the companies can be re-ranked and the portfolio adjusted to include new companies with higher scores and to eliminate companies in the current portfolio which have dropped in score A portfolio of the top 10–25 companies using this method and a relatively simple scoring equation box has been shown to greatly exceed the S&P 500 and other Indexes in price gain over a ten year period.

63 Claims, 11 Drawing Sheets

Although the book Security Analysis by Graham and Dodd fills up more

than 700 pages, the basic message can be summarized by the phrase gin of safety.”

“mar-In the chapter “Survey and Approach,” the authors state: “An ment operation is one which, upon thorough analysis, promises safety ofprincipal and a satisfactory return Operations not meeting these require-ments are speculative.”

invest-And Graham admits a few paragraphs later that “The phrases

thor-ough analysis , promises safety, and satisfactory return are all chargeable

with indefiniteness,” although their basic points are clear If someonegives you an inside tip that stock XYZ is going up, then clearly you havenot yet done thorough analysis If you leverage up your portfolio 200 per-cent and buy just one stock, then you probably have not promised your-self much safety And if you lose money, then chances are your return wasnot satisfactory

But let’s look at Graham’s approach to safety more closely, since Ithink this is the underpinning of all of Buffett’s trading and investing,whether it is in stocks, bonds, arbitrage situations, or even insurance

Graham and Dodd state, “The safety sought in investment is not

absolute or complete; the word means, rather, protection against loss underall normal or reasonably likely conditions or variations.” And then a few sen-tences later the authors add, “A safe stock is one which holds every prospect

of being worth the price paid except under quite unlikely contingencies.”However, as Graham later notes when discussing the fates of the fixedincome bonds offered by railroads before the Depression, “even a high mar-gin of safety in good times may prove ineffective against a succession ofoperating losses caused by prolonged adversity.”

So what are we to do? Graham states later in the chapter on fixed valueinvestments, “The only effective means of meeting this difficulty lies in fol-lowing counsels of perfection in making the original investment Thedegree of safety enjoyed by the issue, as shown by quantitative measures,

must be so far in excess of the minimum standards that a large shrinkage

can be suffered before its position need be called into question Such apolicy should reduce to a very small figure the proportion of holdings aboutwhich the investor will subsequently find himself in doubt.”

GRAHAM-DODD

He gives as an example the General Baking Company bonds paying 5.5percent interest The company itself earns 20 times the amount of its annualinterest payments Graham notes that this is safe and that if the earningsper year decline to only four times the interest payments, then it might beworth finding a safer investment.

Graham-Dodd likes stocks that trade below their liquidating value,where the liquidating value is roughly all of the current and long-term assetsminus all of the current and long-term liabilities on the balance sheet Asthey state in the chapter “The Significance of the Current-Asset Value” in

Security Analysis:

The phenomenon of many stocks selling persistently below their uidating value is fundamentally illogical It means that a serious error is being committed either: (a) in the judgment of the stock market; (b) in the policies of the company’s management; or (c) in the attitude of the stockholders toward their property.

liq-During the Depression, all of these items were applicable The market

as a whole was going down as speculators pulled their money out en masse.Management, not anticipating how bad things were getting, was dissipatingtheir assets And even long-term investors, in need of cash just to survive,were pulling money out of stocks regardless of any value in the stocks.However, ultimately, these types of stocks were what Graham called

“investment bargains.” Specifically:

Common stock which: (a) are selling below liquid asset values; (b) are apparently in no danger of dissipating these assets; and (c) have formerly shown a large earning power on the market price may be said to truly constitute a class of investment bargains They are indu-

bitably worth considerably more than they are selling for, and there

is a reasonably good chance that this greater worth will sooner or later reflect itself in the market price At their low price these bargain stocks actually enjoy a high degree of safety, meaning by safety a relatively small risk of loss of principal.

One possible criticism is that these types of plays no longer exist.They existed in the Great Depression, but never since However, we willsee in the case of Buffett’s personal portfolio that he was able to playthese situations even in the late 1990s We will look at more Buffett exam-ples in a moment

But first, my own foray into this phenomenon occurred on December

11, 2002, when I wrote the following article on thestreet.com’s sister siteStreet Insight

The Cash Index, James Altucher, Street Insight, December 11, 2002

Let’s look at a couple of rules from the greats Benjamin Graham’s favorite rule was to find companies that were trading for less than cash and then hold onto them until they were trading for more than cash Warren Buffett’s two rules are: Rule #1: Don’t lose money Rule #2: Don’t forget rule #1 Warren Buffett was a student of Graham’s for many years As Buffett put it, “the secret to success is figuring out who to be the batboy for.” Buffett was Graham’s batboy and Buf- fett’s rules for investing are directly related to the “margin of safety,” as Gra- ham put it, that you get when you buy stocks that are debt-free and trading for less than the cash in the bank.

It sounds simple-if someone is holding a check with your name on it, it is probably worthwhile to figure out how to cash that check At first glance, it seems mystifying Why doesn’t someone just buy all the shares of the company and then put the cash in his pocket? It is never that easy and the way to make money in arbitrage situations, even as simple as these, is to conduct thorough risk management and due diligence on the stocks involved.

When looking at these stocks, it is important to accept the first premise: they are trading for less than cash for a reason And that reason is that the mar- ket thinks they will run out of cash and eventually declare bankruptcy, render- ing the shares worthless (hence the negative enterprise value).

Some of the risks involved include:

commitments can be tied up in leases, severance packages, unprofitable deals that have cash penalties to back out of, etc.

pursuing until the bitter end a business model that has no chance of turning profitable Great examples from the past include MTHR (MotherNature.com), TGLO (theglobe.com), VSTY (VarsityBooks.com), which never could shake the chains of their strategy until the money ran out.

some cases, management has direct control over the millions of dollars ting in the bank Why would they give that up just to end up unemployed?

Some of the possible exit strategies that can be enjoyed by holders of panies trading for less than cash include:

share-holder (MBOs are the only legal form of insider buying), but we will look at a case below where on an annualized basis we think the risk/reward is there.

opportunity to step on the brakes without worrying about a crash and see

if they can turn the business around A notable example was TSCM, which earlier this year traded below its cash levels and has since rebounded.

create shareholder value when possible and there have been cases where the board has determined the only way to do that is to dividend out the cash to shareholders.

the business model has some potential for survival, many of the stocks listed below are either potential takeover candidates or are already in the process of being taken over, in which case a very direct merger arbitrage analysis can take place Recent companies trading below cash that have been taken over include VCNT, taken over by Microsoft, presumably to help them compete with the MapQuest product offered by AOL Time Warner.

busi-ness lines and merge with a profitable company A recent example is SOFN, which went from $120 million in cash to about $60 million when they wound down their broadband businesses and then merged with a profitable insurance company, causing a 40 percent jump in their stock price When developing the cash index presented below, we established eight selection criteria and weighted them accordingly Our goal was to take out, as much as possible, some of the risks mentioned above, as well as to look for companies that could be considered possible takeover candidates.

1 Market cap < cash Obviously a criterion, but more importantly, that

cash had to be made up of only cash in the bank plus short-term ments We left out companies with little cash but significant inventory or long-term investments.

invest-2 Debt/Equity < 0.20 If management is to have any chance of turning the

situation around, they cannot be plagued with debt commitments or debt

covenants Also, the lack of debt gives the stockholder some degree of confidence that bankruptcy isn’t in the near future.

3 Market Cap + Annual Burn Rate < Cash I like to know that if the

com-pany continues to burn money at its current rate, then the comcom-pany can still be liquidated a year later so I can ideally get my money back, at the very least.

4 Some stability in revenues and earnings Ideally the company will

already have begun a turnaround (profits this year as opposed to losses last year) but my primary concern is that revenues are still not dropping at

a rate of 50 percent a year with losses still doubling In some cases enues will drop, but losses will decrease because the companies are wind- ing down their businesses That is fine for us.

rev-5 A reasonable belief that the sell-off in the stock was partly tional While not a quantitative measure, it is useful to look at the situa-

irra-tion and understand at a glance why the company’s shares sold off and why that sell-off might have been “guilt by association.” For instance, hun- dreds of Internet companies went bankrupt, but not every company whose shares sold off will go bankrupt Later, we will look at examples from the Internet, software, and aviation industries A company that recently went past its cash levels, and so is not included on this list, is CAMZ, a software company which catered to the IPP industry (a double whammy in the eyes

of shareholders who initially sold off their shares).

6 Favorable arbitrage analysis In the instances below where the

com-pany has already accepted a takeover offer, we want to make sure that owning the shares right now still has a high likelihood of having a favor- able annualized return.

7 Insider buying While not a requirement, it is nice to know that senior

officers and directors in the company feel as we do: that the company should be trading for higher than its cash levels.

8 Institutional ownership We like to see mutual funds with above-average

track records that focus on value opportunities swooping down onto these opportunities Among the mutual fund families that we look for include: the Royce Funds, the Clipper Fund, Heartland, and Artisan.

EXHIBIT 2.3 PCYC

Pharmacyclics is a pharmaceutical company focused on the development of products that improve existing therapeutic approaches to cancer and

atherosclerosis.

• $27–29 million annual burn rate.

• Warren Kanders, chairman of Armor Holdings, and a shareholder activist who successfully won a proxy to be on CLRS’s board has recently started

a similar battle to be on PCYC’s board.

• Insider buying from the CFO last May at higher prices than current.

• Royce funds own 450,000 shares.

Price Cash/Share Book/Share Cash Market Cap

The Cash Index as of December 11, 2002 included: PCYC, CLRS, AMIE,PRTS, FAVS, VCLK, NTRT, GEMS, STRD, CPCI, and IATV (see Exhibits2.3–2.13 for a discussion of each stock) (Each exhibit reflects the price andattributes that caused me to write about it on December 11, 2002.)

Source: Reproduced with permission of Yahoo! Inc © 2004 by Yahoo! Inc YAHOO! and the YAHOO! logo are trademarks of Yahoo! Inc.

Graham-Dodd and a Dose of Fisher 25

Clarus Corporation develops, markets, and supports Internet-based to-business e-commerce solutions that automate the procurement, sourcing, and settlement of goods and services.

business-• Warren Kanders successfully won his fight to be on the board of directors and sell off all of their revenue-producing (and money-losing) assets.

• $10–12 million annualized burn.

• Significant insider purchases by several directors, including Kanders.

• Recently hired Morgan Joseph & Co Inc to look into possible reverse

merger opportunities.

• Significant increase in institutional ownership over the past month

(422,000 more shares bought than sold by institutions).

Price Cash/Share Book/Share Cash Market Cap

Source: Reproduced with permission of Yahoo! Inc © 2004 by Yahoo! Inc YAHOO! and the YAHOO! logo are trademarks of Yahoo! Inc.

• Stock sold off, in part, because of recent spin-off where shareholders

chose to keep shares of the spun off company Many people bought into the original company because of the student travel business, which has now been spun off as EPAX.

Price Cash/Share Book/Share Cash Market Cap

Source: Reproduced with permission of Yahoo! Inc © 2004 by Yahoo! Inc YAHOO! and the YAHOO! logo are trademarks of Yahoo! Inc.

Graham-Dodd and a Dose of Fisher 27

First Aviation Services, Inc is one of the leading suppliers of aircraft parts and components to the aviation industry worldwide, and is a provider of supply chain management services, including third party logistics and

inventory management services, to the aerospace industry.

• $1.65 million EBITDA, $68,000 net income in the most recent quarter.

• Sales down 4% Year over Year (YoY) in the most recent quarter, suggesting some stability despite worldwide slump in the aviation industry.

• CEO and several directors recently purchased shares.

Price Cash/Share Book/Share Cash Market Cap

Source: Reproduced with permission of Yahoo! Inc © 2004 by Yahoo! Inc YAHOO! and the YAHOO! logo are trademarks of Yahoo! Inc.